Market review: Are investors becoming numb to risk?

Market review: Are investors becoming numb to risk?

by Kristina Hooper, Global Market Strategist, Invesco Ltd., Invesco Canada

Stocks barely hiccupped last week despite the onslaught of geopolitical headlines. But the big news was that volatility hit a historic low of 9.77 – its lowest level in more than 20 years – last week.1 Clearly, the world has not become less volatile, so what could this indicate?

Measuring the ‘fear gauge’

By way of background, the VIX Index (which is the volatility figure that I cited above) measures the implied volatility of at-the-money, 30-day options (both puts and calls) on the S&P 500 Index. If there is greater demand for options, which typically occurs when investors become worried with their portfolio positions and seek to protect them, then the price of options increases and the VIX moves higher. That’s why the VIX is known as the “fear gauge.” Conventional market wisdom suggests that the higher the VIX, the greater the implicit expectation of a stock market decline.

Now it’s worth noting that there are two types of volatility – implied and realized. Implied volatility is what’s measured by the VIX – it’s what investors expect to happen in the very near term. Realized volatility is what actually has happened — it is the standard deviation of the S&P 500 Index; in other words, it measures how much the index moves, or disperses, over the course of a time period.

Typically, implied volatility is higher than realized volatility but is closely correlated with it. Both measures of volatility are at very low levels. The VIX has experienced a significant decrease in just the past few weeks, as it briefly rose above 16 on April 17.2 In the past year, it’s been even higher, above 22 on Nov. 4 with the U.S. presidential election a few days away and even higher at the time of the Brexit vote.2 And volatility is not just down for stocks – it is also down for other asset classes.

Geopolitical risks abound

So what has happened? Has geopolitical risk diminished in the past few weeks? That seems to hardly be the case. While Emmanuel Macron won the French presidential election, relieving the uncertainty about France’s future in the European Union, North Korea recently accused the U.S. of attempting to assassinate its leader and said it views that as a declaration of war. North Korea underscored its aggressive stance with a nuclear missile test firing over the past weekend.

Last week also saw the firing of FBI Director James Comey, and the reverberations from that action will likely push back the timetable for the Trump legislative agenda – with some pundits even suggesting that it reduces the likelihood of his agenda coming to fruition. Also causing concern were the massive cyberattacks that hit multiple countries and companies on May 12 and could continue this week.

Why is volatility so low?

There are a few different explanations for why volatility is so low. The first is that investors may have decided to focus on fundamentals. As of May 12, 75% of companies beat their mean earnings estimate while 64% beat their mean revenue estimate for the first quarter (that’s with 91% of companies reporting).2 It has been a positive earnings season: Corporate earnings have beaten expectations by 6.0%, which substantially exceeds the trailing five-year average of 4.1%.2

Another explanation is that the S&P 500 Index and the VIX may be skewed because there are a relatively small number of very large-cap companies that dominate the S&P 500, which has lowered volatility and pushed the price of that index higher.

There are, of course, other possible reasons — one being that we may be looking at the wrong “fear gauge” given that the bond market has historically been a more accurate predictor of risk. But perhaps the answer is simply that elevated risk has become the real “new normal.” Investors may be becoming immune to the geopolitical chaos around them, dismissing it as white noise.

Takeaways for investors

While ignoring market noise is typically a sound strategy for long-term investors, it could become dangerous if and when geopolitical events do threaten fundamentals. That doesn’t usually happen, but in my view, investors can’t ignore the possibility and need to pay close attention to the implications of geopolitical risks. One way to potentially do that is by considering strategies that don’t simply track the market, but that focus on company fundamentals – examples include high-conviction active strategies and smart beta strategies. It is critical to understand not only your investment goals but which fundamentals, such as valuation, earnings and revenues, anchor your decision-making process.

This post was originally published at Invesco Canada Blog

Copyright © Invesco Canada Blog

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